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Tightening Tantrum Hits Currencies, Bonds

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Rising US interest rates and a strong dollar have triggered a repeat of the “Taper Tantrum” from five years ago, with emerging-market currencies and local-currency bonds in frontier markets bearing the brunt of the storm. With the Federal Reserve likely to continue raising rates this year, the broad-based sell-off in emerging-market assets could dog the markets for months to come.

The situation worsened in May, with Argentina going hat in hand to the International Monetary Fund (IMF) and the Turkish lira hitting a series of record lows. J.P. Morgan’s emerging market currencies index fell to its lowest in 12 months. Economists said a full-blown default in Venezuela appeared inevitable.

Public debt positions across the emerging world have come under scrutiny recently, and the risks appear to be concentrated in frontier markets, according to London-based Capital Economics. The aggregate debt-to-GDP ratio of frontier governments has risen sharply, as commodity producers have turned to debt issuance to finance large budget deficits, the firm says in a recent report.

Meanwhile, corporate borrowing in emerging-market countries has risen, leaving companies exposed to higher servicing costs, particularly on dollar-denominated debt, when rates go up and local currencies fall. The Institute of International Finance says many emerging markets are now more exposed to a rising dollar than they were in 2009.

The sell-off in EM assets that began in early April looks relatively large compared with those triggered by rising US treasury bond yields over the past 18 months, says William Jackson, senior emerging markets economist at Capital Economics. However, the sell-off has been much less severe than those driven by rising treasury yields between 2013 and 2015, he says. This reflects the fact that emerging markets’ economic vulnerabilities have declined over the last five years, Jackson says.

“Current account deficits have narrowed, and currencies don’t look overvalued to the same extent,” Jackson says. “Turkey and Argentina are the two major emerging markets that stand out, due to their large current account deficits. And it’s hardly surprising that they have found themselves in the eye of the storm during the latest sell-off.”

Jackson also notes that GDP growth in emerging markets didn’t slow during the Taper Tantrum, so the effects of the current sell-off may be limited.

“Looking ahead, emerging-market assets are likely to remain under pressure over the next 12 months or so, as treasury yields rise further, and investor risk appetite deteriorates,” Jackson says. He says to keep an eye on China’s slowing growth, which could spook investors if policymakers make any misstep.

The executive board of the IMF held an informal meeting on May 18 on Argentina’s request for financial support. “Argentina is now facing significant financial volatility, in part as global financial conditions have tightened, and also following the drought that undermined Argentina’s agricultural output,” IMF managing director Christine Lagarde, said after the meeting. “It is in this context that the Argentine authorities requested our support to help counter this market volatility and protect growth, job creation, and social cohesion in Argentina.” She said the IMF and the Argentine delegation were in discussions that would continue in Washington, DC, in the period ahead.